In recent years, there has been an increase in mergers, asset transfers, and affiliations involving nonprofit organizations. These “business combinations” have been necessary in an environment that has become more challenging for nonprofits to obtain financial support in the form of public and private funding and contributions. The process for pursuing a nonprofit business combination, including use of letters of intent or term sheets, due diligence, and the negotiation and execution of documents to effectuate the combination, is very similar to the process used with for-profit entities. Nevertheless, business combinations involving nonprofits have important differences from their for-profit counterparts because of the unique nature of nonprofits. This article provides an overview of common forms of nonprofit corporation business combinations and highlights some aspects of these transactions that differentiate them from for-profit transactions.

Considerations for Moving Forward with Business Combinations

An initial step in any business combination is determining whether such combination makes sense to the nonprofit. The factors that a nonprofit board needs to take into consideration in such evaluation are very similar to those factors a for-profit board considers, including synergies, cost savings and other efficiencies to be obtained through the combination, work force issues, and the composition of the surviving entity’s board and the make-up of its officers. Moreover, the fiduciary duties imposed on nonprofit directors in acting on business combinations are very similar to the fiduciary duties imposed on for-profit directors. Still, there are some important differences between for-profit and nonprofit business combinations. For instance, a for-profit board needs to consider the financial impact a business combination will have on the entity’s owners (such as shareholders in a business corporation). In the context of a charitable nonprofit corporation, the interests of members may be relevant in a board’s consideration of a merger, but such interests are distinguishable because members do not have an ownership interest in the nonprofit. The differences between for-profits and nonprofits lead to other unique factors that need to be considered by a nonprofit board when evaluating a possible business combination.

If the proposed combination involves a nonprofit being merged out of existence, selling substantially all of its assets or becoming a “subsidiary” of another entity, a main focus of the nonprofit board likely relates to whether the mission of the entity will be carried on by the surviving entity in some respect with adequate resources dedicated to such mission. This may result in a requirement by the nonprofit that the mission of the surviving entity incorporate in some respect the nonprofit’s mission.

Other unique considerations include what will happen to any members of the nonprofit, as well as the proposed use of any institutional funds with donor restrictions (including endowment funds) of the nonprofit.

Similar to the situation involving a for-profit business combination, as the nonprofit commences discussions with another entity regarding a possible business combination, a letter of intent or term sheet (that is often non-binding) helps structure the proposed transaction and process for the combination. In order to protect the nonprofit, it is important to have a binding confidentiality agreement in place prior to any significant discussions between the parties.

Mergers

The Model Nonprofit Corporation Act, Third Edition (MNCA), and most state nonprofit corporation acts, permit a nonprofit corporation to merge with another nonprofit corporation pursuant to a process that is very similar to the process required for for-profit entities. State nonprofit corporation acts also may allow a nonprofit to merge with a for-profit entity, such as a business corporation, limited liability company, or limited partnership. In addition, state nonprofit corporation acts may allow a nonprofit to merge with an unincorporated nonprofit association as well as with an entity that is domesticated in another state. For any merger, it is important to confirm that it is permitted under both the applicable nonprofit corporation statute and the enabling statute for the other entity involved in the merger.

The process for a merger involving a nonprofit corporation is very similar to a merger involving a for-profit entity. It typically includes a plan of merger or merger agreement containing the terms of the merger and any appropriate representations and warranties of the merging parties. It also involves the filing of articles or certificate of merger with the state’s secretary of state. Regardless of whether the nonprofit is the surviving entity, it is generally necessary to obtain board of director approval as well as member approval if the nonprofit has members.

Depending on the type of entity that will be the surviving entity in the merger, there may be unique state law requirements, as well as requirements imposed on the nonprofit because of its tax-exempt status. A merger involving a charitable nonprofit can be subject to additional requirements if the charitable nonprofit is being merged out of existence and the surviving entity is not a charitable nonprofit. Some states impose requirements that steps be taken to ensure that the charitable assets or the fair value of such assets of a merged out entity continue to be used for a charitable purpose. A similar requirement is imposed on entities that have tax-exempt status under Section 501(c)(3) of the Internal Revenue Code (IRC). Additional requirements under the IRC are imposed on nonprofits that are private foundations. In addition, some states require a merger be approved by a governmental body, such as the state attorney general, or a court. Where there needs to be action taken to ensure the fair value of the charitable assets is preserved, a valuation by an independent appraiser is likely necessary.

There are significant benefits with regard to proceeding with a merger as the form of business combination. Similar to state for-profit entity acts, state nonprofit corporation acts provide that all assets and rights and liabilities of the merged out entity are automatically transferred/assumed by the surviving entity. There also is no need to dissolve the merged out entity because it no longer exists as a legal entity. In addition, state nonprofit corporation acts often will provide that any bequest, devise, gift, grant, or promise contained in a will or other instrument of donation inures to the surviving entity unless it is made pursuant to an instrument that specifically provides otherwise.

A main disadvantage to a merger is that the surviving entity inherits all of the liabilities of the merged out entity and it is not easily possible to unwind the arrangement if it is later determined that the combination has not resulted in the benefits the parties expected. As a result, it is extremely important as part of the due diligence process to determine what assets and liabilities might be assumed by the surviving entity.

Some state nonprofit corporation acts also permit the consolidation of nonprofits, which is very similar to a merger of a nonprofit with another nonprofit. The main distinction between a merger and consolidation is that a consolidation results in both nonprofits effectively being merged out of existence with the creation of a new entity. A main disadvantage with proceeding with a consolidation as opposed to a merger is that in a consolidation it is necessary to make an application to the IRS if the new entity seeks to have tax-exempt status under Section 501(c)(3) of the IRC. Given the similar treatment of mergers and consolidations of nonprofits, more recent state nonprofit corporation acts have dropped the concept of consolidation.

Asset Acquisitions/Sales

Another form of business combination involves the acquisition or sale of assets of an entity. This might be in the form of a nonprofit acquiring the assets of another nonprofit or a for-profit. Alternatively, the transaction might involve a for-profit acquiring the assets of a nonprofit. The structure of such a transaction is very similar to the structure of an acquisition of assets involving for-profit entities. In particular, the selling entity transfers certain identified assets and liabilities to the acquiring entity.

Similar to a merger, the process for the sale of all or substantially all of the assets of a nonprofit is governed by the state nonprofit corporation acts. The MNCA and most nonprofit corporation statutes provide that a sale by a nonprofit of all or substantially all of its assets generally requires approval by the nonprofit corporation’s board of directors as well as the members if the nonprofit has members.

Often, the form of asset purchase agreement used is very similar to the form used in for-profit transactions and will include a description of the assets being transferred, the liabilities being assumed, and appropriate representations and warranties regarding such assets and liabilities and the parties. Still, such agreement likely will need to include provisions that are unique to a nonprofit. For instance, in the situation where a non-charitable entity is acquiring the assets of a charitable entity, the buyer may require that, as a condition of closing, the seller deliver any approvals necessary from state governmental authorities for the sale of the seller’s charitable assets.

A significant difference between an acquisition of the assets and liabilities of a nonprofit versus a for-profit can relate to the purchase price. If the acquisition involves two nonprofit entities, it may not be necessary for the acquiring nonprofit to pay fair market value (or anything) for the assets. Instead, the transaction can be structured as a gift of assets from the selling nonprofit to the acquiring nonprofit. Such gift should be permissible as long as the “selling” nonprofit corporation’s creditors are paid in full upon liquidation of the nonprofit.

A gift structure is not possible in the event the nonprofit is acquiring assets from a for-profit entity, or a for-profit entity is acquiring assets from a nonprofit entity. To the extent a charitable nonprofit is selling its assets to a non-charitable entity, such as a business corporation, similar to the situation in mergers, state nonprofit corporation acts often require that there be fair value paid for the assets. In addition, many states impose requirements that the nonprofit obtain approval from a governmental body (such as the attorney general) or a court in order to proceed with the transaction. In such situation, it would be important to obtain an independent valuation of the assets as part of the transaction.

A main advantage of an asset transaction is that the acquiring nonprofit is able to be selective in terms of the assets and liabilities it acquires. As a result, it can avoid being burdened with liabilities of the other entity. A main disadvantage is that additional steps may need to be taken in order to complete the transaction. These include obtaining assignments of any relevant revenue generating agreements including consents from the other parties to such agreements. In addition, the selling entity remains in existence and its board will need to take steps to either wind down its activities and dissolve or continue its existence.

Parent-Subsidiary Type Arrangements

Nonprofit corporations differ from for-profit entities in that nonprofits have no owners, whereas for-profits have shareholders or other owners. Still, a parent-subsidiary structure can be structured with nonprofits. The main difference is that the “parent” nonprofit does not own any shares or other interest in the nonprofit. Instead, it is treated as the parent because of the control it has over the other nonprofit. This might be as a result of the “parent” nonprofit becoming the sole voting member of the “subsidiary” nonprofit. It also could be accomplished by the parent nonprofit having the right to determine the directors of the subsidiary nonprofit. Another important difference between a nonprofit and for-profit parent-subsidiary structure is that nonprofits are unable to file consolidated tax returns with the IRS.

The arrangement, which is sometimes referred to as an “affiliation” of nonprofits, can be accomplished by amendments to the articles of incorporation and bylaws of the “subsidiary” nonprofit. These documents would be amended to reflect that the “parent” organization either as the sole member (with sole voting rights) of the “subsidiary” or having a right to determine the board of directors of the subsidiary.

Because this type of combination or affiliation is similar to a merger or acquisition of assets, parties often enter into some type of affiliation agreement that covers similar topics addressed in other business combination agreements. For instance, an affiliation agreement might address any change in activities of the subsidiary nonprofit as well as the composition of the parent’s board of directors as well as certain representations and warranties about the parties and their operations.

One of the main advantages of a parent-subsidiary type structure is that the parent does not assume the liabilities of the subsidiary entity. In addition, the affiliation often can be easily accomplished by amending the governance documents of the “subsidiary” entity. This type of structure is also attractive to entities that are not certain about the “permanency” of the arrangement and would like the ability to “unwind” the business combination if it is subsequently determined that the combination is not working out. The unwinding of the business combination can be accomplished through amendments to the governing documents to take the “parent” organization out of the control position of the “subsidiary.”

A disadvantage to this type of business combination is that the parties may not achieve the efficiencies that can be obtained through a merger. In particular, there will still be two separate entities that need to file their own Form 990s with the IRS. There also will be a need to keep in place two separate boards of directors (although the subsidiary board can be quite small and meet infrequently, assuming that the parent board is addressing issues relevant to the subsidiary). Some organizations that choose to use this type of structure will – through a merger – collapse the “subsidiary” into the “parent” at some later point in time when it is determined that the combination should be permanent.

A variation of this structure is the incorporation of a third nonprofit corporation that becomes the sole member (or parent) of the existing nonprofit corporations. This may be attractive to nonprofits that see themselves as “equals” to each other. The advantages to such a structure are similar to the advantages of the “parent/subsidiary” structure. One disadvantage is that a new nonprofit corporation needs to be incorporated and likely needs to obtain tax-exempt status. In addition, the IRS has shown some disfavor to granting tax-exempt status to entities that are merely holding companies with no operations. As a result, it may be necessary to have some activities of the combined nonprofits occurring at the “parent” level.

Forms of Less Integrated Affiliations

Although beyond the scope of this article, it is noted that nonprofits can be involved in other types of arrangements that result in organizations combining their resources to a lesser extent. For instance, two nonprofits may enter into arrangements for joint funding, joint programming, combined services, or other type of joint venture. These types of arrangements allow the involved nonprofits to maintain their autonomy while achieving some efficiencies. It is also possible for nonprofits to enter into joint venture arrangements with for-profit entities. Such arrangements raise tax issues that can impact the structure of any joint venture.

Similar to business combinations involving for-profits, due diligence activities are important for business combinations involving nonprofit corporations. Many of the considerations for a for-profit business combination are important in due diligence reviews involving a nonprofit business combination. These include reviewing various information and documents relating to the other entity, including its governance documents (such as articles of incorporation, bylaws, and board policies), financial information (including audited financial statements and any audit reports), contractual arrangements, real and personal property, litigation, insurance coverages, and workforce/employees (and employee benefits).

Still, given the unique nature of nonprofits, there are other factors important to business combinations involving nonprofits that should be considered as part of the due diligence process. Below is a description of some of these considerations.

The tax-exempt status of any nonprofit involved in a business combination is important and should be confirmed through a review of the determination letter issued by the IRS. In addition, there should be a review of recent Form 990 federal tax filings for the nonprofit.

Many nonprofits are exempt from paying property taxes on their real estate as a result of being a nonprofit. This can mean significant savings to the nonprofit. Because exemption for property tax is not automatically determined on the basis of whether an entity is tax-exempt under the IRC, the parties to a business combination need to consider whether the resulting transaction will jeopardize any existing property tax exemptions.

Many nonprofits depend on public and private funding as well as bond financing. The terms of such funding and financings should be reviewed to determine whether the particular form of business combination will impact the continued existence of such arrangements. In addition, many nonprofits have institutional funds that have restrictions imposed on them by their donors. As noted above, in the context of a merger, any such funds presumptively are transferred to the surviving entity unless there are restrictions that prohibit such transfer. It is important that the restrictions be considered as part of the due diligence process to ensure that a transfer is possible and that the surviving entity is able to honor such restrictions.

As described above, a business combination involving a nonprofit corporation may require approval by the nonprofit’s members if it has any. For nonprofits with members, it is important to determine whether such “members” meet the state nonprofit corporation act’s definition of members. Typically, such definition focuses on individuals or entities that elect part or all of the board of directors. It is possible that a nonprofit may have a group of individuals designated as “members” who do not have such rights. In such circumstances, it may not be necessary to obtain their approval of the merger (or other business combination) unless the articles or bylaws of the organization mandate such approval.

As also described above, to the extent the business combination will result in an entity, other than a charitable nonprofit, as the surviving entity, it may be necessary to obtain state attorney general or court approval. Such determination should be made as part of the due diligence process.

Conclusion

A merger, asset transaction, or other business combination involving a nonprofit corporation has many characteristics that are similar to those of a business combination involving for-profit entities. Nevertheless, a business combination involving a nonprofit is not a typical M&A transaction and, due to the unique nature of a nonprofit, there are important differences that need to be addressed when considering such a business combination.